Sunday, March 14, 2010

An Ecological Perspective on Financial Market Reform

Financial practices such as leverage and maturity transformation have been getting a lot of attention in the aftermath of the recent crisis. Consider, for instance, the following comments by William Dudley from a speech he gave in November:

Turning [to] inherent sources of instability, there are at least two that are worthy of mention. The first instability stems from the fact that most financial firms engage in maturity transformation — the maturity of their assets is longer than the maturity of their liabilities. The need for maturity transformation arises from the fact that the preferred habitat of borrowers tends toward longer-term maturities used to finance long-lived assets such as a house or a manufacturing plant, compared with the preferred habitat of investors, who generally have a preference to be able to access their funds quickly. Financial intermediaries act to span these preferences, earning profits by engaging in maturity transformation — borrowing shorter-term in order to finance longer-term lending.

If a firm engages in maturity transformation so that its assets mature more slowly than its liabilities, it does not have the option of simply allowing its assets to mature when funding dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened. Maturity transformation means that if funding is not forthcoming, the firm will have to sell assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets are lower quality. In that case, the forced asset sales are likely to lead to losses, which deplete capital and raise concerns about insolvency.

The second inherent source of instability stems from the fact that firms are typically worth much more as going concerns than in liquidation. This loss of value in liquidation helps to explain why liquidity crises can happen so suddenly. Initially, no one is worried about liquidation. The firm is well understood to be solvent... But once counterparties start to worry about liquidation, the probability distribution can shift very quickly toward the insolvency line... because the liquidation value is lower than the firm’s value as a going concern...

These sources of instability create the risk of a cascade... Once the firm’s viability is in question and it is does not have access to an insured deposit funding base, the next stop is often a full-scale liquidity crisis that often cannot be stopped without massive government intervention.

If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short. It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that. CIT did die. Mexico in 1994. When you can’t roll over your short term debts, it gets really ugly, and fast... The phrase, “You can always refinance,” is a lie... Long-dated assets should be financed by non-putable long-dated liabilities or equity. Don’t cheat and finance shorter than the life of the assets involved. There is never an assurance that you will be able to get financing on terms that you will like later.

In his report on the Lehman bankruptcy, the court-appointed examiner Anton Valukas observed that "demands for collateral by [its] lenders had direct impact on Lehman’s liquidity" and that the resulting inability to obtain short-term financing "is central to the question of why Lehman failed." As Barry Ritholtz points out, however, this was a proximate rather than ultimate cause of the bankruptcy:

So what actually kills the patient — the disease that ravages the body, destroys its naturally ability to fight off invaders, and leaves it totally vulnerable? Or whichever random infection finally does them in?

In the case of Lehman Brothers, the disease that left them vulnerable was a mad embracing of risk, the excess use of leverage, an extensive exposure to mortgage and real estate, and the enormous usage of derivatives — concurrent with a lack of intelligent risk management.

Citi and JPM were merely the opportunistic infections that came along at when Lehman’s immune system was compromised. That is why you never want to allow yourself to become that vulnerable on Wall Street.

Note that if Lehman were the only firm engaged in such practices, we would probably have had a contained bankruptcy rather than a full-fledged financial crisis:

On Monday September 15, Lehman Brothers... was allowed to go into bankruptcy... It was a game-changing event with catastrophic consequences... the price of credit default swaps... went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.

But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to “break the buck” – stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing.

The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support.

None of this would have been possible without extensive maturity transformation and high levels of leverage across a broad range of financial institutions, making them all simultaneously vulnerable to a liquidity shock. But how did this level of fragility arise in the first place?

As far as I am aware, there are few economists who have attempted to shed light on the process that gives rise to changes over time in systemic financial fragility. An important exception is the late Hyman Minsky, who developed what might be interpreted as an ecological theory of financial practices. I have discussed his ideas at length in a previous post, but they are worth revisiting in light of the Lehman report.

Central to Minsky's theory is the idea that at any point in time there is a distribution of financial practices in the economy, ranging from prudent debt structures with ample margins of safely to highly aggressive positions involving significant leverage and maturity transformation. In particular, Minsky draws a distinction between hedge financing and speculative financing. The former refers to a debt structure in which expected cash flows in all future periods are large enough to meet contractual debt commitments. Unless revenues are unexpectedly low, therefore, there will be no need for such a firm to roll over its debt. Speculative financing refers to a debt structure in which cash flows are expected to lie below debt commitments in some periods. In this case the firm anticipates that it will need to refinance, and is therefore vulnerable to changes in interest rates and the availability of credit.

Minsky is interested in the manner in which the distribution of financial practices -- the extent of hedge relative to speculative financing in the economy -- changes over time. The proximate determinants of such changes are differential rewards: those practices associated with the highest realized returns will tend to proliferate through reinforcement, imitation, and flows of capital to successful firms. As long as a liquidity crisis is averted, the prevalence of speculative financing will therefore increase. This effect is amplified by the fact that speculative financing results in faster economic expansion and asset appreciation:

The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well. The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well. Acceptable liability structures are based upon some margin of safety, so that expected cash flows, even in periods when the economy is not doing well, will cover contractual debt payments. As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event it becomes apparent that the margins of safety built into debt structures were too great. As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. This increase in the weight of debt financing raises the market price for capital assets and increases investment. As this continues, the economy is transformed into a boom economy." (Minsky, 1982)

The inevitable result of a progressive shift towards increasingly aggressive financial practices is a rise in system fragility. When a liquidity crisis eventually arrives, it is the most highly leveraged firms that face bankruptcy. I summarized this process in a 2002 review as follows:

During stable expansions, profits accrue disproportionately to firms with the most aggressive financial practices, resulting in an erosion of margins of safety. This raises the probability that a major default will trigger a widespread crisis. When a crisis does eventually occur, its most devastating impact is on the highly indebted firms that prospered during the expansion. Balance sheets are purged of debt, margins of safety rise, and the stage is set for the process to begin anew. From this perspective, expectations of financial tranquility are self-falsifying. Stability, as Minsky liked to put it, is itself destabilizing.

Those who recognize that such a process is underway can make a killing when the crisis eventually erupts, but will make steady losses in the interim and must have deep enough pockets to hold on. If they are managing other people's money, they may face major withdrawals of cash precisely when their expected returns are highest (this is the central insight in Shleifer and Vishny's analysis of the limits of arbitrage).

One cannot, therefore, simply rely on self-correcting market mechanisms to keep such crises at bay. What should one do instead? The ecological perspective suggests that static approaches to financial sector reform (such as curtailing the use of certain types of contracts or shifting over-the-counter transactions to exchanges) may not be enough. What is required is a more dynamic policy response that makes aggressive financial practices more costly at precisely those points in time when fragility is greatest. As long as prudence doesn't pay, the injunction that "long-dated assets should be financed by non-putable long-dated liabilities or equity" will surely continue to fall on deaf ears.

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Update (3/18). For anyone interested in reading more about the ecological approach to financial market behavior, Macroeconomic Resilience has a number of posts on the topic; see especially this one on parallels and complementarities between Minsky's ideas and those of the Canadian ecologist Buzz Holling.

8 comments:

Rajiv,countercyclical regulation of financial sector is very important for avoiding crises, but I think that the first line of defense should be more aggressive monetary and fiscal response properly calibrated to stabilize AD. We should promote countercyclical regulation of leverage, but we cannot rely on the success of such regulation because of enormous public choice problems.

Yes, another great post. I'm frustrated by the amount of misdirected energy spent identifying "bad" guys (hedge funds, investment banks, bonuses), "bad" instruments (credit default swaps, derivatives) and policy solutions that are unlikely to have made much difference in averting the GFC (the CFPA).

Focusing on the underlying structural problems such as those you identified is much more likely to help avert future crises. Competitive pressures make it very difficult for companies to choose to take the more expensive long-term financing, which would result in worse margins year after year during a long bull market, likely losing market share in the process.

I have been convinced that limits on leverage of too-big-to-fail financial firms would be necessary, but perhaps the approach of enforcing longer-term financing would be better targeted and more effective. However it seems like this might be difficult to regulate.

Do you have an idea of what sort of dynamic policy levers could be used to increase the cost of short-term financing?

Bruce, it's not the cost of short-term financing as such that one wants to change, it's the use of short-term financing for the purchase of long-dated assets at times when the system as a whole is fragile. To do this one needs to have a measure of maturity transformation at the level of an individual firm, as well as an economy-wide measure of fragility. Once could then think about raising capital requirements for particular firms in particular periods. This would have to be done in a transparent, rule-based manner so that financial planning is not disrupted. In any case, your question is a good one, and I'm not sure that there are any convincing answers out there.

Rajiv, how do you know ex ante, for the economy as a whole, how much leverage is too much? And further, don't you think that having a transparent rule for systemic "fragility" only makes things more unstable as certain market players (ie those too big too fail) will push the system to its bailout point by leveraging up in those sectors of finance not covered by countercyclical capital requirements?

This is not to say that a fragility measure such as you suggest would not be helpful. It is only to point out that judgement is native to the regulatory/monetary policy problem. We don't think of the judicial process as reducible to an algorithm; justice is just too complex for that. But monetary/financial policy, possibly more complex, is thought to be reducible in principle even if not in practice.

The deep issue here is not simply "use of short-term financing for the purchase of long-dated assets at times when the system as a whole is fragile." It is that the production process is itself takes time and is therefore "illiquid" by definition, whereas the circulation process requires liquidity. This is why maturity and liquidity transformation are necessary to a monetary economy, leave alone a capitalist one.

Calibrating the capillary provision of "banking" is therefore akin to adjusting the temperature in the hothouse that is a monetary economy. Minsky was wise not to reduce such a problem to a model, however complicated the latter may be, because he knew he was dealing with a shape-shifter.

By no means am I advocating that we throw the macro-control effort out of the window. All I am suggesting is that we search for heuristics with the knowledge of the tenuousness of our control efforts. Hence margins of safety, which work best when socialized.

The unvarnished scientism of economic control needs to be augmented by the considered judgement of the statesmen if we are going to free ourselves of the diabolical use of economics by politics. So along side the search for novel "levers," we need to be thinking about ways we can development that other rigorous tool, human judgement and expertise viz. macro-control. If you are hearing an echo of Dreyfus's critique of AI, then I have managed to make sense.

Opedwala, I didn't mean to sound too dogmatic about the issue of rules versus discretion, and agree that judgment calls have to be an essential part of any regulatory policy. My point was simply that frequent and capricious changes in capital requirements will be very disruptive and could cause more trouble than they are worth. So any dynamic policy response has to be grounded in some basic, transparent principles. But your broader point is well taken.

I'd call attention, however, to one important non-regulatory development (or at least indirectly regulatory development) that addresses some of these concerns: the structure of the typical private equity firm.

Private equity firms (including the subtype called hedge funds) have blossomed of late. And, while the hedge funds did lose value in the financial crisis despite pledges that they were immune to business cycles (and many shuttered), they did much, much better than their publicly held peers with an equity product as opposed to a debt or even subordinated debt product, during the financial crisis.

Private equity firms typically lock in investors for much longer time periods (often 3-5 years) than other players in the same capital markets. They fill some of the gap that was created during the most recent couple of booms when investment banks went from being owned by their active and formerly active partners (who were locked in for even longer time periods) to being third party investor owned.

Significant locked in long term equity acts like long term debt for arbitrage purposes. On the source of funds side of the balance sheet, from a temporal perspective, they look more like old fashioned savings and loans that have lots of customers invested in long term CDs than they do like modern investment banks with short maturity paper.

The fact that private equity funds have, as their name implies, big equity cushions (i.e. relatively low leverage), also makes them fairly modest sources of systemic risk. They have to take very big hits for anyone but management to suffer.

Finally, private equity strongly aligns investor and management interests in controlling risk because carried interests (which look more like equity stakes with significant downside risk rather than like stock options that lack a downside) are such an important piece of the compensation package.